The perfect match-up
Global Head of Pension Asset Management
• Location: Heidelberg
• Assets: €3,82bn
• Members: >80,000
• Type of fund: Defined benefit (multiple locations)
Investment-grade corporate fixed-income investments take up 15% of the assets of the pension funds operated by HC affiliates. We have another 5% or so embedded in multi-asset or specialist return-seeking strategies, which would include the full spectrums of liquid to illiquid, high-quality to high-yield, and plain-vanilla to esoteric private debt investments.
Corporate bonds complement our overall LDI strategy, providing a degree of matching of both the duration and spread elements that feed into valuation of our liabilities. They provide some pickup in yield to support our return objectives, though this is a lesser objective.
We also use the more esoteric forms of private debt to further enhance returns by taking advantage of premia that reward other less traditional risks, such as illiquidity and complexity. These also support the overall objective of broadening diversification and reducing overall risk.
Our strategy consists of decomposing the risk factors inherent in our liabilities, and then addressing them by matching up or avoiding various types of assets, depending on how they address or add to those risks. In that respect, corporate debt is just another tool in the box.
Our core LDI portfolios have been fairly defensive in terms of hedging interest-rate and inflation risks and have been relatively constant in that respect since 2007, but we have flexed our exposure to corporate debt at a few points during that period.
Our return-seeking allocations, including the multi-asset strategies and speciality allocations, have been far more tactical and opportunistic over the same time. As a result, our funds have had exposure to various spaces in the credit markets over the years, and most of the have been fortunate to have been early adopters with first-mover advantage in a number of them.
Six years of somewhat extraordinary measures by policy makers have had the effect of keeping default rates low despite huge dislocations in both the private and public debt markets. One might reasonably worry that they are getting a lot less bang for the buck as time goes by, so I would be reluctant to embrace corporate bonds simply in the expectation that they might continue to have a low default rate, and more likely to view corporate bonds as a necessary diversifier of the increased risks of default across all sectors of the private and public debt markets.
Lombard Odier Pension Fund
Lead portfolio manager
• Location: Switzerland
• Assets: €901.7m
• Members: 2,183
• Type of fund: Defined benefit
We manage our portfolio on a risk allocation basis. That is the big picture to keep in mind when we discuss our asset allocation. That means we look at a number of risk premia and allocate funds to ‘risk buckets’, not with fixed weights but according to a target risk allocation.
We identify five major risk premia – duration, credit, equities, emerging and inflation. All these risks are linked to the economic cycle and each can provide some extra yield at different times. Our method of measuring risk is not solely linked to volatility. We use a bundle of different metrics that feed into a broad measure, which we merge into an expected shortfall. Our annualised expected return target is cash plus 3% over a full business cycle.
In normal conditions, on average we would allocate about 20% of risk to credit. In the current environment, we actually cannot reach that target. Broad risk in the credit market is so compressed now that if you wanted to reach that number you would have to make use of leverage, which we can’t for our pension fund.
A 20% risk allocation translates into a capital allocation that can fluctuate quite a bit – at the moment we have about 20% to 25% of funds allocated to what most investors classify as credit products, but that includes pure credit bond funds, while further credit risk is embedded in several sovereign bond, emerging debt and convertibles strategies. There are different drivers for the risk allocation to corporate credit in the portfolio. We take into account carry, as we do for all asset classes, by measuring spreads. We also look at volatility or tail risk, adjusted for liquidity risk, which is quite high in this asset class.
We cannot invest in high yield because our minimum rating allowed for credit securities is BBB. Our goal for credit is exposure to carry. In the case of credit, with spreads as low as today, you would be tempted to significantly reduce exposure to the asset. But if you weigh the opportunity of staying in cash instead, it’s much better to keep your credit holdings, get paid your coupon and benefit from carry over time until risk conditions change and warrant portfolio reallocations.
Stichting Pensioenfonds Medisch Specialisten (SPMS)
• Location: Zeist, Netherlands
• Assets: €7.8bn
• Members: Approx. 15,000
• Type of fund: Defined benefit
We allocate 4.5% of our overall portfolio in euro-denominated and 6% in US dollar-denominated corporate bonds, and we will keep it this way for the time being. Our corporate credit holdings are not likely to change in the near future.
We are satisfied with the yield we are receiving and, because we don’t see any significant development in the sector ahead, we are going to maintain this allocation for the next 12 months. The spreads are low, but also the amount of defaults in that portfolio.
We generally use our corporate bond holdings to achieve a return that is slightly higher than sovereign debt. This means that we will focus only on investment grade bonds and disregard high-yield paper. I personally do not think that, at this stage, high-yield returns as it should do, given the risk that we would have to expose ourselves if we were to invest in that market. As a means of comparison, I believe that emerging market debt pays better. As a result, SPMS has invested some capital in emerging market corporate debt.
Corporate bonds are an asset class fits that within our overall target as a fund and, most importantly, we use the asset class to match our liabilities. However, for liability matching purposes, we will only use the euro-denominated portion of the portfolio.
We are not looking to reduce or increase our corporate debt exposure, but we are indeed going to reduce our equity exposure. We think that equities have reached a fair valuation at this point. The opportunities that were there five or six years ago have been realised and, going ahead, it will be difficult to achieve the same returns we have seen in the past years.
The same argument could be made about credit – but we would say, because we do not see any catastrophe coming in the corporate credit market, we would not reduce our exposure.
We will indeed look at emerging market equities but, in general, we will reduce our exposure. Instead ,we aim to increase our allocation to real estate – even to the illiquid type, such as infrastructure projects.